CDOs and the Mortgage Market

Collateralized debt obligations (CDOs) are a type of structured investment finance product that contain various assets and loan products. Investment banks package bank loans, mortgages, and other assets into collateralized debt obligations—similar to funds—for institutional investors to buy.

Key Takeaways

  • Collateralized debt obligations (CDOs) are structured investment products that contain various assets and loan products.
  • The credit products are repackaged and grouped into tranches based on the credit risk appetite for the investors buying the CDO.
  • The goal of creating CDOs is to use the debt repayments—which would typically be made to the banks—as collateral for the investment.
  • Standard & Poor's (S&P) is one of the companies that provide investors with independent credit ratings on CDOs.
  • If the loans within a CDO are mortgage loans, the product is often referred to as a mortgage-backed security (MBS).

Understanding CDOs and the Mortgage Market

The goal of creating CDOs is to use the debt repayments—which that would typically be made to the banks—as collateral for the investment. In other words, the promised repayments of the loans and bonds give the CDOs their value.

As a result, CDOs are cash flow-generating assets for investors. Although CDOs are typically associated with the mortgage market, they can include various types of investments and debt—such as mortgages, corporate bonds, lines of credit, auto loans, and credit card payments. All of these credit products are repackaged and grouped into tranches based on the credit risk appetite for the investors buying the CDO.

If the loans within a CDO are mortgage loans, the product is often referred to as a mortgage-backed security (MBS). If the mortgage loans in the CDO were made to borrowers with less than stellar credit or no credit history, they're called subprime mortgages. Although the term "subprime" often pertains to mortgages, other credit products have subprime categories, including auto loans, credit lines, and credit card receivables that are higher risk.

CDO Credit Structure

Initially, all the cash flows from a CDO's collection of assets are pooled together. This pool of payments is separated into rated tranches. Each tranche also has a perceived (or stated) debt rating to it. Credit and debt products are assigned credit ratings, which measure their likelihood of default. Default occurs when a party can't pay back interest and principal amounts from a loan or financial instrument.

Standard & Poor's (S&P) is one of the companies that provide investors with independent credit ratings as well as being the provider of the S&P 500 Index. The top tier rating is usually "AAA" rated senior tranche. The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings, and the lowest junk or unrated tranches are called the equity tranches. Each specific rating determines how much principal and interest each tranche receives.

The AAA-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk. On the other hand, the lowest-rated tranches usually only receive principal and interest payments after all other tranches are paid.

Furthermore, they are also first in line to absorb defaults and late payments. Depending on how spread out the entire CDO structure is and depending on the loan composition, the equity tranche can generally become the "toxic waste" portion of the issue.

Investing in CDOs

Typically, retail investors can't buy a CDO directly. Instead, they're purchased by insurance companies, banks, pension funds, investment managers, investment banks, and hedge funds. These institutions look to outperform the interest paid from bonds, such as Treasury yields. However, these companies assume an added level of risk with buying CDOs that accompanies the additional rate of return.

Of course, the added risk levels that CDOs exhibit might adequately be compensated by the higher returns in a stable economic environment; however, if the economy falls into a recession, the risk of default on the mortgage loans that act as collateral for CDOs can rise dramatically. The result can lead to losses for CDO investors.

Asset Composition Complications

To make matters a bit more complicated, CDOs can be made up of a collection of prime loans, near-prime loans (called Alt.-A loans), risky subprime loans, or some combination of the above. These are terms that usually pertain to the mortgage structures.

If a buyer of a CDO believes the underlying credit risk of the loans is investment grade, the firm would likely accept a lower yield that's only slightly higher than a U.S. Treasury. Debt instruments with a low risk of default typically pay a lower interest rate while riskier debts command a higher rate by investors to compensate for the added risk of default.

The Federal Reserve purchased trillions worth of MBSs as part of the quantitative easing program during the Great Recession.

However, the issuer of the CDO can come under pressure if it turns out that the underlying mortgages were much riskier than the yield would dictate. Whether the underlying CDO loans are rated properly is one of the hidden risks in more complicated CDO structures. In other words, the risk of investing in CDOs can increase if the loans made to the borrowers weren't as prime as the lenders had initially believed.

Other Complications

Other than asset composition, other factors can cause CDOs to be more complicated. For starters, some structures use leverage and credit derivatives that can trick even the senior tranche out of being deemed safe.

These structures can become synthetic CDOs that are backed merely by derivatives and credit default swaps made between lenders and in the derivative markets. A credit default swap is essentially used by buyers of CDOs as insurance against non-payment. The buyer shifts the risk of the CDO's non-payment by buying the CDS through an insurance company or other CDS seller in exchange for a fee.

Many CDOs get structured such that the underlying collateral is cash flows from other CDOs, and these become leveraged structures. This increases the level of risk because the analysis of the underlying collateral (the loans) may not yield anything other than basic information found in the prospectus.

Care must be taken regarding how these CDOs are structured because if enough debt defaults or debts are prepaid too quickly, the payment structure on the prospective cash flows will not hold and some of the tranche holders will not receive their designated cash flows. Adding leverage to the equation will magnify any and all effects if an incorrect assumption is made.

The simplest CDO is a 'single structure CDO,' which poses less risk since it's usually based solely on one group of underlying loans. It makes the analysis straightforward because it is easier to determine the expected cash flows and the likelihood of defaults.

Special Considerations

The CDO market exists since there's a market of investors who are willing to buy tranches–or cash flows–in what they believe will yield a higher return to their fixed income portfolios with the same implied maturity schedule.

Unfortunately, there can be a huge discrepancy between perceived risks and actual risks in investing. Although CDO buyers may believe that the product will perform as expected, credit defaults can happen, and there is often very little recourse.

It may become difficult to unwind a position to stop the losses if the credit markets are deteriorating and loan losses are increasing. In such an environment, the market can dry up, meaning there could be no liquidity. The result can lead to investors trying to sell their CDO positions, only to find there are no buyers.

The Emergence of CDOs

CDOs came into existence in order for banks to sell off their loans, creating room on their balance sheets, so that they could take on more loans. It is a way to generate more profits by (1) selling off current loans and (2) making money from new loans.

CDOs were a niche product in the early 2000s but quickly grew to become widespread through Wall Street and beyond. They created many jobs as they required quantitative analysts and computer programmers to model the valuations of the loans that made up the CDO. In addition, CDOs needed to be marketed and sold to investors, which required hiring salespeople to sell them.

CDOs, particularly mortgage-backed securities (MBSs), contributed to the subprime meltdown in 2007/2008 that led to the Great Recession. Many of the mortgages were valued incorrectly and many of the bundles were rated inaccurately as they did not appropriately factor in some of the less creditworthy loans. After the recession, CDOs fell out of favor, however, started making a comeback a few years later.

The Collapse of CDOs and the Great Recession

The banks that packaged CDOs and sold them to investors were not extremely thorough in their analysis of the people they were making loans to. As the banks sold off the loans, so too did they sell off their risk. The quality of the borrower wasn't a huge concern to them and so banks were making loans to people with poor credit and people were taking out mortgages that they couldn't afford.

The amount of liquidity in the market eventually created a bubble that was apparent in the housing market, credit cards, and the automobile market. As housing prices increased, people kept buying houses, quite often to flip them and turn a quick profit.

The government brought some stability to the financial markets by purchasing CDOs.

In addition, investors purchasing CDOs weren't aware of the quality of all the loans in the CDOs. They trusted banks to price the risk appropriately and for rating agencies to rate the CDOs appropriately, neither of which was happening.

Eventually, housing prices fell and individuals weren't able to make payments on their mortgages. When people defaulted, this caused the income streams in CDOs to decrease or cease, impacting the investors that bought them, causing losses. These investments were spread widely throughout the financial markets; in mutual funds, pension funds, and corporations. The losses spread quickly.

Will CDOs Ever Disappear?

Regardless of what occurs in the economy, CDOs are likely to exist in some form, because the alternative can be problematic. If loans cannot be carved up into tranches, the end result will be tighter credit markets with higher borrowing rates.

As long as there is a pool of borrowers and lenders out there, you will find financial institutions that are willing to take risks on parts of the cash flows. Each new decade is likely to bring out new structured products, with new challenges for investors and the markets.

What Is a Bespoke Tranche Opportunity (BTO)?

A bespoke tranche opportunity (BTO) is a structured financial product that is tailored to an investor's interest in purchasing a specific tranche of a CDO for a specific asset. For example, if an investor wanted to purchase BBB auto loans in a specific region, they would be able to do that through a BTO.

Why Can CDOs Be Risky Investments?

CDOs can be risky because they are complex products. As they are an amalgamation of various loans, understanding the credit quality of those loans is of utmost importance. Most investors rely on the credit ratings issued by rating agencies to understand the quality of the investment, and if those ratings are inaccurate like they were during the subprime meltdown, investors could be purchasing low-quality assets without realizing.

What Is a Synthetic CDO and Do They Still Exist?

Synthetic CDOs are an advanced form of CDOs. While the underlying assets of regular CDOs are traditional fixed-income assets, such as loans, mortgages, and bonds, synthetic CDOs use non-cash assets as the underlying asset, such as credit default swaps, options, and other such contracts. Synthetic CDOs typically offer higher yields than traditional CDOs. And yes, synthetic CDOs still exist.

The Bottom Line

Collateralized debt obligations (CDOs) are structured financial products that allow investors access to non-traditional investments that they would otherwise have a difficult time gaining exposure to, such as mortgage and auto loans. A CDO whose underlying assets are mortgages is known as a mortgage-backed security (MBS).

MBSs take numerous mortgages and package them into one product with various tranches. The tranches are of varying risk depending on the risk of the underlying mortgage. Investors receive income payments from the MBS that are derived from the mortgage payments on the loan.

Article Sources

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  1. S&P Global. "S&P Global Ratings Definitions."

  2. BIS. "Structured Finance Then and Now: A Comparison of CDOs and CLOs."